Market Fundamentals Affect Investor Trading Activities
Uninformed investors tend to overreact to firm-specific factors and underreact to market-wide factors while informed investors exploit the trading patter of uninformed investors.
ANN ARBOR, Mich. Some investors trade because they have private information regarding the value of a stock, while others trade to rebalance portfolios and better diversify risk or because they are subject to behavioral biases like overconfidence or loss aversion.
These two types of traders exhibit different trading patterns because informed traders will enter only one side of the tradebuy upon receiving good news and sell upon receiving bad news, say University of Michigan Business School researchers. On the other hand, uninformed traders are likely to participate in either side of the trade.
In a study of 40 stocks on the New York Stock Exchange over a 10-year period from 1993 to 2002, Professor Guojun Wu and doctoral student Qin Lei examine how traders of different types react to changes in market conditions. They investigate the information content of stock trading as a result of the dynamic interaction between informed and uninformed traders.
Generally speaking, the proportion of information-based trading is lower for active stocks than for infrequently traded securities. The reason, say Wu and Lei, is that while high-volume stocks tend to have a larger flow of informative events and more trading activities by informed investors, the uninformed traders' higher levels of activity actually more than offset these factors. With less active stocks, however, there is a greater probability that any trade comes from an informed trader.
Trading activity for uninformed investors depends largely on the past performance of a stock and the overall market, according to the researchers. They report that when past stock returns are high for the 20-day prior period, uninformed traders tend to adopt a "contrarian" strategy and sell significantly more stocks than they buy. However, when past market returns are high over the previous 20 days, uninformed traders are more apt to adopt a "momentum" strategy and to submit more buy orders for stocks than sell orders.
"These results seem to suggest that uninformed investors overreact to firm-specific factors and underreact to market-wide factors," says Wu, an assistant professor of finance at the Michigan Business School.
Informed traders closely monitor market movements and respond rationally to any change in the trading activity of uninformed traders so they can best exploit the "camouflage" provided by uninformed traders, the researchers say.
For example, they found that informed traders seek to match the level of trading activity by uninformed traders on stocks with large uninformed dollar volume, although the increased presence of the informed traders undercuts the efforts of matching. The estimated probability of this matching response ranges from 0.72 to 0.98 among the group of 40 NYSE stocks, reflecting the fact that informed traders actively seek the cover-up afforded by the increased level of uninformed trading activities.
Wu and Lei argue that the time series of estimated probability of informed trading is a good predictor for various measures of bid-ask spreads. Higher average opening spreads are observed among stocks with higher information asymmetry. Stocks with low dollar volumes have higher opening spreads because of their potentially higher inventory costs and the higher information asymmetry that occurs in less frequently traded equities.
The researchers conclude, however, that information asymmetry, measured by the probability of informed trading, is more significant than dollar volume in explaining the variation in average opening spreads. The estimated probability of informed trading also has predictive power over mean bid-ask spreads in the next trading day and surpasses two competing measures of information asymmetry, they say.
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